China's Latest Reform Shouldn't Be Its Last

When the Chinese government proposed this week to end its decades-long policy of capped bank lending, there was good reason to be skeptical about its motives. China had just had its biggest weekly stock plunge since 2008. The new policy -- which would scrap a rule limiting bank lending to 75 percent of deposits -- seemed like the government's latest attempt to artificially sustain economic growth at 7 percent.

That suspicion may be entirely justified. But it's too soon to know for sure. Removing restrictions on bank lending could also turn out to be a big step by President Xi Jinping toward internationalizing China's financial system and putting it on more solid long-term footing.

But that will hinge on whether Xi has the courage to go one step farther, by ditching the government-imposed ceiling on deposit interest. Such a shift, which China's central bank calls one of the "riskiest" the country must consider, would prove Xi is willing to put market forces in control of the country's financial system.

Removing the cap on interest rates that lenders pay on deposits would show the Communist Party is prepared to tolerate the uncertain effects of an open competition for cash. While it would mark a vital step toward internationalizing the yuan, it would also be a financial Pandora's Box. The increase in volatility in the banking system could mean higher borrowing costs for companies, including the state enterprises that dominate China and enrich the Communist Party bigwigs looking over Xi's shoulder.

That's why Xi's party would probably prefer to put off reforming interest rates for a few more years. But in the absence of a such a shift, Tuesday's lending-cap proposal will only serve to gin up stock prices -- at least until the stock bubble bursts.

Yesterday's 3.5 percent plunge in the Shanghai Composite suggests investors are beginning to sense China's rally is mostly driven by momentum, not corporate earnings. Xi's team hasn't backed up the 124 percent surge in Shanghai shares over the past 12 months with structural changes to the Chinese economy. Moves to rein in state-owned enterprises have been vague and modest. The shadow-banking system Beijing pledged to curtail still churns out untold trillions of dollars of credit. Economic policy still favors smokestack industries that blacken China's skies over services.

China's worsening debt profile makes the stock boom look even more ephemeral. For a sense of the scale of China's debt problem, consider Bloomberg's recent reporting on the northern port city of Tianjin. The city had planned to build its own Manhattan skyline dotted with ultra-modern skyscrapers, riverside parks and six-lane highways. Today, it looks more like the set of a post-apocalyptic zombie movie. Local-government debt alone now exceeds the $3.7 trillion of currency reserves Beijing has spent the last 15 years amassing. The Communist Party underwrote this mania by cutting the cost of opening trading accounts and creating new avenues for margin lending. It also mounted a huge PR offensive to cloak share ownership in patriotic terms.

The good news is that Xi still has a window to get serious about putting China's financial house in order. Two private-sector gauges of economic activity -- HSBC's purchasing managers’ index and a survey from advisory firm China Beige Book -- suggest the government's stimulus efforts are gaining traction. Recent moves to ease monetary policy and bolster provincial finances have increased the odds economic growth will approach Beijing's target for the year. Even property "has started to show signs of improvement after 11 consecutive months of price decline," says Liu Li-Gang of Australia & New Zealand Bank. All this should give Xi breathing space to pursue more ambitious reforms, including on deposit interest.

Still, as long as China's stock gains are outpacing its fundamentals, there's reason to fear a massive fallout. At the moment, there are two ways for financial turbulence in China -- whose $10 trillion economic output is now roughly double Japan's and nearly eight times South Korea's -- to reverberate around the globe: a debt crisis or plunging equities. Policy makers from Seoul to Brasilia can only hope both don't crash at once. With his shift on bank lending policy, Xi may be signaling that he's ready to create a more rational economic system. All the rest of us can do is hope the skeptics are wrong.

This column does not necessarily reflect the opinion of Bloomberg View's editorial board or Bloomberg LP, its owners and investors.